Financial Instruments and Markets: A Casebook

25

Note on Credit Derivatives

A derivative is a contingent contract that derives its value from changes in the specified risk of an underlying, which could be a particular asset or a reference index. In contrast to cash instruments, derivatives are primarily used to transfer risk rather than value. As such, they are meaningful contracts even when their value is zero.

Derivatives are typically identified by the type of risk that causes changes in their value. Interest rate derivatives (such as interest-rate swaps) fluctuate with the changes in interest rate, equity derivatives (for instance stock options) with equity prices, and commodity derivatives (such as commodity futures) with commodity prices. Some derivatives embody more than one type of risk, such as cross-currency swaps, which simultaneously transfer both exchange rate risk and interest rate risk, or basis swaps, which trade one type of risk for another. A credit derivative is a contingent agreement that subjects the timing and amount of its settlement cash flows, and consequently its value as well, to the changes in the designated underlying's credit risk.

CREDIT RISK

Simply put, credit risk is the risk that a borrower (the obligor) won't pay back the lender. When pricing credit derivatives, this risk is most visibly shown in the spread between the promised yield on a defaultable bond or loan and the yield on the default-free U.S. Treasury bond of the same maturity. This is known as the yield spread. The following formula ...